CFM Due Diligence & Fund Selection 2 — Questions and Answers
Question 1: During operational due diligence, which document most directly reveals how a fund handles cash movements between investor accounts and trading accounts?
- Limited partnership agreement
- Cash management policy (Correct answer)
- Side pocket disclosure
- Subscription agreement
Correct answer: Cash management policy
A fund's cash management policy details the controls and procedures governing how cash is moved between accounts, a key operational risk area.
Question 2: A fund manager claims a 3-year track record but recently replaced the lead portfolio manager. How should a due diligence analyst treat this performance history?
- Accept it fully as the fund's track record
- Discount it since strategy continuity may be broken (Correct answer)
- Reject the entire track record as non-representative
- Annualize only the period under the new manager
Correct answer: Discount it since strategy continuity may be broken
When key personnel change, past performance may not reflect future management style, so the track record should be discounted or contextualized accordingly.
Question 3: Which metric best measures a fund manager's ability to add value relative to the risk taken, specifically adjusting for systematic market exposure?
- Sharpe ratio
- Jensen's alpha (Correct answer)
- Calmar ratio
- Sortino ratio
Correct answer: Jensen's alpha
Jensen's alpha measures excess return above what is predicted by the CAPM given the fund's beta, isolating manager skill from market risk.
Question 4: In fund selection, what is the primary purpose of reviewing a fund's Form ADV Part 2?
- To assess trading volume and liquidity
- To understand fees, conflicts of interest, and investment strategies (Correct answer)
- To verify GIPS compliance of performance data
- To evaluate the fund's leverage ratios
Correct answer: To understand fees, conflicts of interest, and investment strategies
Form ADV Part 2 is the investment adviser's disclosure brochure covering strategies, fees, disciplinary history, and conflicts of interest.
Question 5: A fund's Sharpe ratio improves from 0.6 to 1.2 after a methodology change in return smoothing. What concern does this raise?
- The fund has reduced its market beta
- Return smoothing may be artificially reducing reported volatility (Correct answer)
- The risk-free rate used in the calculation decreased
- The fund shifted to lower-risk asset classes
Correct answer: Return smoothing may be artificially reducing reported volatility
Return smoothing can suppress reported volatility, inflating the Sharpe ratio and masking true underlying risk in illiquid or opaque portfolios.
Question 6: Which of the following best describes 'style drift' in fund due diligence?
- A manager gradually increasing management fees over time
- A fund deviating from its stated investment mandate or strategy (Correct answer)
- Regulatory changes forcing a shift in asset allocation
- A fund's benchmark index rebalancing its components
Correct answer: A fund deviating from its stated investment mandate or strategy
Style drift occurs when a fund manager deviates from the stated investment style or mandate, potentially altering the risk-return profile investors expected.
Question 7: When evaluating a hedge fund's prime brokerage relationship during due diligence, why is counterparty credit quality important?
- It determines the fund's annual audit fee
- Assets held at a failing prime broker may be at risk of loss or freeze (Correct answer)
- It sets the maximum leverage ratio the fund can employ
- It determines the management fee calculation basis
Correct answer: Assets held at a failing prime broker may be at risk of loss or freeze
If a prime broker fails, as seen in the Lehman Brothers collapse, fund assets may be frozen or lost, representing significant counterparty risk.
CFM Due Diligence & Fund Selection 2
During operational due diligence, which document most directly reveals how a fund handles cash movements between investor accounts and trading accounts?